The beginning of investment wisdom is to recognize the circumstances that lead to poor decisions and thereby cut down on the damage done by investment mistakes. Behavioral Finance seeks to help us understand our errors in decision making and reasoning, or what is scientifically called; cognitive errors or biases - biases lead to predictable but suboptimal decisions. The research done in behavioral finance stems from work in the area of cognitive, social psychology and economics, which is the study of how people, including investors, think, reason, and make decisions and when understood can steer us into making better investment decisions.
The first investment howler is not investing at all.
The reason many people do not invest varies, from lack of knowledge, fear, distracted by too much information and choice to procrastination and status quo bias - lack of money should not be an excuse, but the fact remains; the costs are immediate, yet the benefits are deferred and people in general seek immediate gratification, so they put off doing what they know is in their long term best interest and follow the path of least resistance.
Most of the time maintaining the status quo does not involve mental activity and therefore the easiest option is to stick with the status quo and procrastinate, for example by keeping money in a non-interest bearing deposit account or a low interest savings account.
Procrastination also results from the desire to avoid emotional distress. Behavioral Finance scientists indicate that some people fear financial investment decision making or planning because they anticipate that it will be a painful experience, we fear financial losses more than we appreciate financial gain, so we do nothing, which is known as loss aversion, or as Adam Smith famously wrote in the 19th century: "We suffer more when we fall from a better to a worse situation, than we ever enjoy when we rise from a worse to a better."
Carefully thought through investments into shares can often lead to greater increase of our wealth - and shouldn't one of our life goals be financial freedom and the peace of mind it brings?
I believe planned investment decisions need to be as much part of people's lives in the 21st century as healthy eating and keeping fit.
The second investment howler is taking your money out too soon, or not!
We plan on investing for the long term but we get swayed by market noise and our emotions take over.
Neuroscientist and former Wall Street Trader Dr. John Coates says: "Money may be the last thing about which we can remain cool." Dr. Coates indicates that the cerebellum is the area of the brain most engaged when making financial decisions and when overcome with emotion: "the cerebellum is impaired, as it is when we are drunk." He also describes the impact of an inner 'biological storm' of fear which compels us to react, sadly memories of bad financial decisions are stored in our body, causing us to: "relive them over and over again, so that stress hormones linger in our brains, promoting a pathological risk aversion, even depression, and circulate in our blood, contributing to recurrent viral infections, high blood pressure, abdominal fat build up and gastric ulcers."
Is it any wonder we react as we do to the market noise and sell our shares? In fact the biological impact on our body is far more likely to take place when we react to the market noise. Alan Greenspan studied very carefully the black Monday crash of October 2007 and said he could not find one reason, not one, on why the market should have crashed so dramatically, there was no sensible information, just human reaction which caused a cascade of selling and a dramatic drop in the market price.
The reason for the biological reaction will be because we have made a decision to sell not on solid researched information but on emotion and market paranoia.
Warren Buffett likes to say the: "best time to sell shares is never." And the "best time to buy is when everyone is selling." Buffett holds quality stock for the long term and the annual dividends provide significant upside. So look for companies that regularly pay annual dividends (check their last 5 or 10 years dividend history and, if you can, reinvest the dividends into the stocks.
The temptation to sell, of immediate gratification creates a gap between intentions and actions, and we know that gap is the place we often suffer.
It is always worth remembering that cognitive dissonance stems from the fact that; we don't like to admit our mistakes, even to ourselves.
What are your investment howler tips?